Analysis of the Government spending of Costa Rica

A project report submitted in partial fulfillment of the requirements of the

course EEP-I, Term 2, 2017-19: PGPM

Submitted
By
GROUP NO. 10
Anubhav Saraswat (17P186)
Mahwish Farooqui (17P204)
Mayank Pandey (17P207)
Pratyush Chawla (17P215)
Vatsalya Kumar Srivastava (17P234)
Sujay Vatsa (17P240)

Submitted to
Prof. Subhalakashmi Sircar

MANAGEMENT DEVELOPMENT INSTITUTE

Gurgaon

December 2017
 DECLARATION

This is to certify that the project titled, “Analysis of the Government spending of Costa Rica”,
is a piece of original research done by Anubhav Saraswat, Mahwish Farooqui, Mayank Pandey,
Pratyush Chawla, Vatsalya Kumar Srivastava and Sujay Vatsa, in partial fulfillment of the
requirements for course on EEP-I, Term 2 (2017-19: PGPM) at Management Development
Institute, Gurgaon. Our indebtedness to other works has been duly acknowledged at the
relevant places.

GROUP No.10

Anubhav Saraswat (17P186)

Mahwish Farooqui (17P204)
Mayank Pandey (17P207)
Pratyush Chawla (17P215)
Vatsalya Kumar Srivastava (17P234)
Sujay Vatsa (17P240)

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Abstract

Compared to that of other Latin American countries, the economy of Costa Rica has
been very stable. Emerging from a recession in 1997, it has shown strong growth since then.
Inflation hovered at around 4 to 5% for several years up to 2015 but dropped to 0.7% in 2016.
In 2017, the poverty level in Costa Rica dropped by 1.2% to 20.5%. Though poverty level
remains high, the standard of living in Costa Rica is quite high primarily to reducing inflation
and benefits provided by the government.
In the initial part of the 20th century, the economy was based primarily on agriculture.
The economy has however matured and now evolved into that of a more diverse one, based on
tourism, medical components exports, electronic components medical manufacturing and IT
services. In 2016, 5.5% of the GDP was generated through agriculture, 18.6% through industry
and 75.9% through services. As far as the labor distribution is concerned, Agriculture employs
12.9%, industry 18.57% and services 69.53%
In this report we have analyzed the expenditure side of the GDP of Costa Rica for the
past five years from 2012 to 2016. The growing debt and budget deficit are the primary
concerns which the country faces. The country was facing difficulties in paying its obligations
and drastic changes were promised by the government to solve the liquidity crisis it was facing.

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Table of Contents
Abstract ...................................................................................................................................... 2

Introduction…………………………………………………………………………………....4

Costa Rica’s Economic Analysis (2016-

15)…………………………………………………..10

Costa Rica's Economic Analysis (2015-14) ...……………………………………………… 11

Costa Rica's Economic Analysis (2014-13) ...…………………………...………………… 13

Costa Rica's Economic Analysis (2013-12).…….………………………………………… 15

Costa Rica's Economic Analysis (2012-11) ……………..…………………………………..16

References……………………………………………………………………………………17
.

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Introduction

Costa Rica is a tropical country located on the isthmus of Central America between the
Caribbean Sea to the east, the Pacific Ocean to the west, and between Nicaragua to the north
and Panama to the southeast, lying between 8-12 degrees north of the equator. The country has
a total area of around 51,100sq km, slightly smaller than the US state of West Virginia. In 2011,
Costa Rica’s population was approximately 4.6 million people, its population growth rate was
estimated at 1.3% per annum (p.a.) - somewhat below the Latin America average of 1.6% p.a.
- and the country continues to experience net in-migration, mostly from Nicaragua, both legal
and illegal. (According to the US Central Intelligence Agency (2012), there are an estimated
300,000-500,000 legal and illegal Nicaraguans in Costa Rica, comprising about 9% of the
population).
Life expectancy in 2011 was reported at 77.9 years, higher than in the US, and the infant
mortality rate in Costa Rica was 9.45 per 1000 live births, as compared to 6.06 in the US.
Almost two-thirds of Costa Ricans live in urban areas, and the rate of urbanization is 2.1% p.a.
The country’s ethnic breakdown is 94% white (including mestizo), 3% black, 1% Amerindian,
and 1% Chinese. Costa Rica boasts greater than 95% literacy for those 15 and older, and in
2009 the country spent 6.3% of its GDP on education (Central Intelligence Agency, 2012). The
World Bank classifies Costa Rica as a middle-income country, and per capita GDP in 2011
was estimated at $11,900 US on a purchasing power parity (ppp) basis (Central Intelligence
Agency, 2012).
With respect to the composition of GDP during the 2006-11 interval, agriculture accounted for
6.3% of GDP (but employed 14% of the approximately 2.16m people in the labor force, a figure
that excludes Nicaraguans living in Costa Rica); industry for 22% of GDP; and services for
approximately 72% of GDP. In 2011, official unemployment was above 7.5%, and Gross Fixed
Investment as a percentage of 2011 GDP was reported at 21.3%, a rate that would be consistent
with moderate growth in future living standards.
In spite of impressive growth in the Gross domestic product (GDP), low inflation, moderate
interest rates and an acceptable unemployment level, Costa Rica in 2017 was facing a liquidity
crisis due to a growing debt and budget deficit. By August 2017, the Treasury was having
difficulty paying its obligations. Other challenges facing the country in its attempts to improve
the economy by increasing foreign investment include a poor infrastructure and a need to
improve public sector efficiency.

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The country has consistently performed favorably in the Human Development Index (HDI),
placing 69th in the world as of 2015, among the highest of any Latin American nation. It has
also been cited by the United Nations Development Programme (UNDP) as having attained
much higher human development than other countries at the same income levels, with a better
record on human development and inequality than the median of the region.
Costa Rica also has progressive environmental policies. It is the only country to meet all five
UNDP criteria established to measure environmental sustainability. It was ranked 42nd in the
world, and third in the Americas, in the 2016 Environmental Performance Index, and was twice
ranked the best performing country in the New Economics Foundation's (NEF) Happy Planet
Index, which measures environmental sustainability, and was identified by the NEF as the
greenest country in the world in 2009. Costa Rica plans to become a carbon-neutral country by
2021. By 2016, 98.1% of its electricity was generated from green sources particularly hydro,
solar, geothermal and biomass.
Costa Rica’s economy is driven mainly by tourism, agriculture, medical components
manufacturing, electronic components and exports. The level of education of the people of
Costa Rica is high and fluency of English of its citizens makes it an attractive destination to
invest.
The foreign companies had in 2016 employed approximately 54000 people from a population
of about 342000 and the provision of corporate services to these companies is the fastest
growing aspect of the economy. Nearly 4.6 billion US dollars were created by this sector in
2016 about as much as was created through tourism. Tourism brought in about 3.4 billion USD
in 2016 and increased from 2.089 million in 2008 to 2.6 million in 2016. In 2016, tourism
directly and indirectly supported 110000 and 271000 jobs respectively.
The geography of Costa Rica consists of mountainous terrain. Costa Rica has abundant rainfall
and it has enabled it to construct a number of hydroelectric power plants. Around 98 % of the
country’s electricity is generated through hydro generating stations, wind turbines, solar panels
and biomass plants.
The major concerns for the government of Costa Rica are Lack of investment and maintenance
of existing infrastructure. The government has emphasized on the need to bring in private sector
companies to overcome this challenge. Costa Rica has been reducing its tariffs in accordance

Fig 1 : GDP figures of Costa Rica from 2007-16

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with Central American countries. United States, Guatemala, the Netherlands, Panama and
Nicaragua constitute the top export countries for all types of product. Refined petroleum,
automobile and agricultural products constitute the most important portion of imports by value.
Coffee, sugar, banana and beef constitute the major part of its exports by value.

Costa Rica lacks mineral resources and this inability forces it to rely on import of fuels
(roughly 11% of total imports). As a result, trade deficit is what the country has been facing
from 1995. The balance of trade for the last five years, 2012-16 shown through the graph
depicts the same.

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Figure 1 Costa Rica’s Balance of Trade 2012-16)

The following table gives the data about various demographic and economic indicators
of Costa Rica.

2012 2013 2014 2015 2016

Population(million) 4.7 4.7 4.8 4.9 4.9

GDP Per capita (US dollar) 9,731 10,449 10,338 10,850 10,737

GDP (USD bn) 45.3 49.2 49.5 52.6 52.7

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 2012 2013 2014 2015 2016

Economic Growth (GDP, annual variation in %) 4.7 2.1 3.0 4.7 4.3

Consumption (annual variation in %) 4.9 2.9 3.4 4.3 4.1

Investment (annual variation in %) 10.4 -1.1 2.9 8.9 -1.5

Unemployment Rate 7.8 8.3 9.7 9.6 9.5

Fiscal Balance (% of GDP) -4.4 -5.4 -5.7 -5.9 -

Public Debt (% of GDP) 34.2 35.8 38.3 40.8 -

Money (annual variation in %) 18.2 11.9 11.6 13.9 7.3

Inflation Rate (CPI, annual variation in %, eop) 4.6 3.7 5.1 -0.8 0.8

Inflation Rate (CPI, annual variation in %) 4.5 5.2 4.5 0.8 0.0

Inflation (PPI, annual variation in %) 3.8 1.4 4.9 -0.4 0.3

Benchmark Interest rate (%) 9.20 6.50 7.20 5.95 4.45

Exchange Rate (vs USD) 512.6 500.7 540.8 537.3 553.2

Exchange Rate (vs USD, aop) 503.1 501.0 537.2 534.6 544.0

Current Account (% of GDP) -5.3 -4.9 -5.0 -4.5 -3.6

Current Account Balance (USD billion) -2.4 -2.4 -2.5 -2.4 -1.9

Trade Balance (USD billion) -6.2 -6.4 -6.4 -5.9 -5.4

Exports (USD billion) 8.7 8.6 9.2 9.2 9.9

Imports (USD billion) 14.9 15.1 15.6 15.1 15.3

Exports (annual variation in %) 7.7 -1.1 5.6 0.7 7.8

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 2012 2013 2014 2015 2016

Imports (annual variation in%) 7.9 1.2 3.1 -2.8 1.3

International Reserves (USD) 6.9 7.3 7.2 7.8 7.6

External Debt (%of GDP) 34.0 39.8 44.0 45.4 48.9

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CHALLENGES: BRIEF LOOK AT NUMBERS THAT MATTER

The World Bank considers Costa Rica a development success story in many respects.
Considered an upper middle-income country, Costa Rica has experienced steady economic
expansion over the past 25 years. The post-1980s economic growth is the product of a
strategy of outward-oriented growth, based on openness to foreign investment and gradual
trade liberalization.

Costa Rica is also a global leader for its environmental policies and accomplishments, which
have helped the country build its Green Trademark. The pioneering Payments
for Environmental Services (PES) program has been successful in promoting forest and
biodiversity conservation; making Costa Rica the only tropical country in the world that has
reversed deforestation.

The combination of political stability, a social compact, and steady growth has resulted in one
of the lowest poverty rates in Latin America and the Caribbean.

According to data from the National Household Survey of the National Institute of Statistics
and Census, the country managed to reduce total poverty from 22.3 to 20.5 percent between
2014 and 2016. In the case of rural poverty, there was a decrease from 30.3 to 25.7 percent
for the same period; and urban poverty, in those same years, fell from 19.5 to 18.6 percent.
Meanwhile, by 2016, 6.3 percent of the country's households are living in extreme poverty.
The country’s success over the past decades is also reflected in its strong human development
indicators, which continue to rank higher than those of other countries in the region.

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Costa Rica’s GDP per capita has tripled since 1960 and its growth averaged 4.5 percent
between 2000 and 2013, compared to the regional average of 3.8 percent for the same period.

During the global crisis, real GDP growth slowed to 2.7 percent in 2008 and contracted to 1
percent in 2009. The economy rebounded following the crisis, achieving an average real
growth rate of 4.9 percent between 2010 and 2012. Growth decelerated to 3.5 percent in
2013, and there was a pick up to 3.7 and 4.3 percent in 2015 and 2016, respectively. This
year, a slight drop to 3.9 percent is expected, and the prospect for 2018 is of 3.7 percent.

Despite the solid growth over the past decades, two pressing development challenges stand
out: the deteriorating fiscal situation and stubborn inequality. These affect the basic pillars of
development: inclusion, growth, and sustainability.

The government has strived to address these problems and is committed to an inclusive
society that guarantees the welfare of its people, supported by transparent and accountable
public institutions.

The following are some noteworthy points about Costa Rica, in relation to its ‘Successful
Development Story’, as called by the World bank.

1. Costa Rica’s economic, social and environmental achievements are impressive

Costa Rica succeeds in combining rising living standards with sustainable use of
natural resources. Incomes per capita have nearly doubled in real terms over the past
three decades. Almost universal access to health care, education and pensions has
been achieved. Careful management of natural resources has emphasized the
protection of forest and the development of renewable energy sources, providing
foundations for the strong eco-tourism industry. As a result, the well-being of most
Costa Ricans is high, as attested by long life expectancy, poverty rates low by Latin
American standards and above-average perceptions of life satisfaction.

2. It is urgent to restore fiscal sustainability

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 The public deficit and debt have risen since the start of the 2009 global crisis. Rating
agencies have downgraded Costa Rica’s debt to below-investment grade and its
country risk spread has risen. To restore the fiscal balance, it is urgent to raise more
tax revenue and curb spending, notably the fast-increasing public-sector wage bill.
Improving the fiscal framework by enhancing its transparency and predictability, and
reinforcing central government control over public finances would strengthen public-
finance management.

3. Policy and institutional reforms will contribute to stronger and more inclusive
growth
Despite strong performance, socioeconomic challenges remain. Policy reforms and
institutional changes could put Costa Rica on a path of stronger and more inclusive
growth. The main priority is to improve the framework of competition policy and
state-owned enterprises’ governance. Productivity would be enhanced by promoting
innovation, access to finance and transport infrastructure. Such reforms need to go
hand in hand with making Costa Rica a more inclusive society, especially for women,
by improving the quality of education and enhancing the effectiveness of cash
transfers in reducing poverty, thus expanding opportunities and sharing prosperity
more widely.

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MAJOR CHALLENGES

Few significant challenges that the group was able to identify in the Costa Rican economic
and financial landscape in the light of recent developments in the country keeping in view the
other influential sectors like politics, are the following-

1. Tax revenues are low and spending is rising fast, pushing public debt to high levels.
The public administration is highly fragmented and the Ministry of Finance has
limited control over total public expenditure.
2. The central bank’s independence in the conduct of monetary policy can be improved
3. Banking-sector competition and financial systemic risks remain concerns
4. The labour-market gender gaps are high
5. The minimum wage structure is very complex. One out of three workers are being
paid below the minimum wage
6. The share of informal employment is high by OECD standards and increasing
7. Spending on education is high, but outcomes are poor. Repetition and drop-out rates
are high
8. Competition is weak and the role of state-owned enterprises is pervasive in many
sectors
9. Low productivity growth and barriers to entrepreneurship are hampering income
convergence
10. Transport infrastructure is deficient due to a complex institutional setting

They all can be segregated under 3 main Areas of Action for the country. These 3 main
recommendations can be summarized as:

1. Restore fiscal sustainability and enhance monetary credibility (Challenges 1-3)

2. Make growth more inclusive, especially for informal workers and women (Challenges
4-7)
3. Adopt policy and institutional reforms to boost productivity growth (Challenges 8-10)

Before discussing these challenges and concluding with recommendations for each of them,
we’ll discuss the vital parameters and the recent economic and political highlights of the
region. Then we’ll go on to discuss main challenges in the light of macroeconomic indicators.
We’ll finally end with tabular recommendations for the 10 challenges recognized earlier.

RECENT ECONOMIC AND POLITICAL HIGHLIGHTS

In recent decades -- since 1990 -- the PLN has been torn between its technocratic branch with
its convictions firmly planted in market-oriented policies and those favoring a return to the
traditional “statist” policies of the center-left. Oscar Aries, who was awarded the 1987 Nobel
Prize for Peace for his role in pacifying Central America after two decades of civil wars, has
served two terms as president, from 1986-90 and, again, from 2006-2010. He played an
indispensable role in shepherding Costa Rica’s ratification of the long-delayed DR-CAFTA
treaty through a national referendum. On the other hand, Ottori Solís, the founding leader of
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the PAC, has steadfastly opposed the treaty because of the changes in national law that would
be required in order to bring Costa Rica into compliance with the treaty. In October 2007, in
a first-ever national referendum, Costa Rican voters narrowly approved the DR-CAFTA
treaty -- concluded in 2004 -- that will lead, over time, to the elimination of almost all tariffs
on exports to the United States. In return, Costa Rica has agreed to improve protections of
intellectual property rights, and obliges Costa Rica to open its telecoms, electricity, and
insurance sectors to competition that have historically operated as state monopolies.
Opposition to ratification was centered mostly in the labor unions, which opposed opening
these sectors to competition.

The next stage is the implementation of the treaty that requires the approval of 13 pieces of
legislation that would bring national law into compliance with the treaty’s provisions
(Thomson, 2007). During the remainder of the second Arias administration the focus was on
formulating investor-friendly policies and improving social welfare measures through
increased spending on education, pensions, and health care. In May 2010, an Arias protégée,
Laura Chinchilla was installed as Costa Rica’s first woman president. A social conservative,
she opposes gay marriage and the disestablishment of the church, in addition to supporting
restrictions on abortion and the morning-after pill, and she has allocated more funds to the
police to combat recent outbreaks of violent crime triggered by increased inequality (say the
left) and drug gangs (say the right).

In addition, President Chinchilla favors more funding for education, improving the business
environment to attract foreign direct investment particularly in the semi-conductor and
medical equipment sectors, as well as attending to the “unfinished business” regarding
amending Costa Rica’s remaining laws that are incompatible with the DR-CAFTA treaty
(The Economist, 2010).

Most recently, the centerpiece of the president’s economic agenda -- a comprehensive fiscal
reform program that includes a major tax overhaul -- looks doubtful for passage in the
legislature owing to the ruling party’s loss of control in the legislature, the government’s
strained relations with the opposition, and the growing unhappiness of most Costa Ricans
with the President’s performance that was exacerbated by a series of corruption scandals in
her government. Of those polled in July 2012, 75% responded that the government is corrupt
(EIU, 2012c).

DETAILED STUDY OF COSTA RICA’S PAST PERFORMANCE

Costa Rica’s strong performance combines rising living standards and a sustainable use of
natural resources. In the past three decades, real GDP per capita has nearly doubled (Figure
1), as the economy has evolved from a rural and agriculture-based economy to one with high
value-added industries linked into global value chains. The process of opening up to
international trade and attracting foreign direct investment (FDI) that started in early 1980s
has diversified the country’s production structure, boosted exports and labor force utilization
(Figure 1).

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Virtually universal health care, pension and primary education systems have led to relatively
low infant mortality, long life expectancy (close to 80 years) and low poverty by Latin
American standards. Costa Rica has also built a world-renowned green trademark and a
strong eco-tourism industry based on wise management of natural resources focusing on
forest protection and renewable energy sources. These successes are reflected in well-being
indicators, which are comparable or even above the OECD average in several dimensions
(Figure 2). Costa Ricans’ life satisfaction is high when compared to OECD countries (Figure
3). Costa Rica ranks also above the OECD average in the community dimension, indicating a
high quality social support network. It ranks similar to the OECD average in health and
environment. By contrast, education stands out for its large gap with OECD countries.

However, challenges have emerged in Costa Rica’s development process. Intel’s recent
decision to replace its manufacturing plant by an R&D centre suggests that Costa Rica should
keep up its structural reforms to shift from labour-intensive sectors toward more knowledge-

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intensive activities. Also, while export-oriented firms are dynamic and innovative due to
inward FDI and well-developed links with global value chains, domestic firms concentrate on
low value-added activities, employ unskilled workers and often operate in the informal
economy, which account for about 40% of total employment. Spill-overs from FDI to local
firms are negligible and the country’s overall productivity growth has been disappointing.
During the recent financial crisis, fiscal problems have resurfaced, with fast-rising public
deficit and debt, calling the fiscal sustainability of current policies into question. As a result,
in 2014 rating agencies downgraded Costa Rica’s debt to below-investment grade.

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This first Economic Assessment of Costa Rica argues that the government should focus on:

 Boosting productivity to avoid the middle-income trap and undertaking structural

reforms focusing specifically on competition, corporate governance of state-owned
enterprises, innovation, education, access to finance and transport infrastructure.
 Making Costa Rica more inclusive by improving social policies, the quality of
education, and reducing informality, thereby expanding opportunities and sharing
prosperity across all Costa Ricans, especially women.
 Strengthening the institutional framework, notably reducing fragmentation; it is
crucial to enhance the Ministry of Finance’s control over public finances and deficit
reduction.

Next, we analyze the recent macroeconomic developments and their implications and the
challenges associated along with them, in detail. We’ll also try to find the solutions that can
be implemented.

RECENT MACROECONOMIC CHALLENGES AND SHORT-TERM PROSPECTS

The economy is recovering from a sharp slowdown

The 2009 global crisis hit Costa Rica and the economy went into recession, with GDP
slowing from about 7.5% over 2005-07 period to -1% in 2009 (Figure 4). The rebound was
rapid, but growth has since been less buoyant than before the crisis and the labour market
remains weak, with high unemployment and rising informality. Inflation has been on a
declining trend since 2009 and even turned negative in mid-2015, reflecting falling
commodity prices, spare capacity in the economy and exchange-rate appreciation. Besides,
inflation expectations have declined, albeit less markedly.

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GDP growth is estimated to have fallen below 3% in 2015, mainly on account of the Intel
plant closure and its significant impact on exports. The ‘El Niño phenomenon’ also hit
agriculture. Low inflation has boosted households’ purchasing power, buttressing private
consumption. Public infrastructure investments are also supporting activity. With the
economy slowing down and inflation sharply lower, the central bank (BCCR) has adopted a
supportive monetary policy stance. It cut the benchmark interest rate from 5.25% in January
2015 to 1.75% in January 2016, well below the nominal neutral interest rate of 4.6%.

Activity is set to accelerate in 2016-17, as global growth and export markets gain momentum
gradually. Unemployment is likely to remain above 9%. Inflation has undershot the previous
central bank target range of 3-5%, owing to low oil prices and the stability of the exchange
rate. In January 2016, the central bank lowered the inflation target range to 2-4%, reflecting
persistently low inflation and in line with inflation developments in main trading partners.
Inflation is projected to gradually move to the new target range as the economy strengthens.
The expected gradual normalization of US monetary policy might result in lower capital
inflows and currency depreciation.

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As Costa Rica is a small open economy, shocks to its trading partners, notably the United
States, will have an important impact on growth, though its limited exposure to China (5% of
exports) protects it from the import decline of that country. Terms of trade improved in 2015,
and further declines in energy prices would raise incomes and growth. On the downside, the
normalization of US monetary policy could put pressure on the exchange rate, causing
tensions in the financial system and, as the private’s sector is highly dollarized, hurting
consumption and investment. Failure to implement the proposed fiscal reform would result in
deficit and debt increases, calling the fiscal sustainability of current policies into question. In
addition, Costa Rica could face large shocks whose effects are difficult to assess and that, for
this reason, have not been factored into the projection (Box 1). On the positive side, Costa
Rica is well protected by the high level of international reserves held by the Central Bank
(about USD 8 billion, 15% of GDP) and by the favorable currency composition of sovereign
debt (about two thirds of central government debt is denominated in domestic currency).

The government has proposed a wide-ranging tax reform to start tackling fiscal
problems

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The general government budget deficit is expected to reach 4.7% of GDP in 2015, from a
slight surplus in 2008, and to exceed 5% of GDP in 2017, based on existing policies. The rise
in the public deficit is mostly attributable to increases in government spending, due largely to

the fast-rising public-sector wage bill (Figure 5). Public debt has grown rapidly from 28% of
GDP in 2009 to more than 40% in 2015 and the ratio of debt to tax revenue has increased
from 1.3 to 1.7 times over the same period. Credit default swaps spreads have increased and
agencies have lowered Costa Rica’s credit rating below investment grade, although
government bond spreads are at the same level as in 2012.

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The government is aware of the fiscal challenge and since 2014 has sought to reduce the
growth of current non-interest expenditure. Spending restraints and tax reform are necessary.
The government is working to bring the budget back to a medium-term sustainable path. The
central government budget deficit increased from 5.7% of GDP in 2014 to about 6% of GDP
in 2015, partially an account of rising interest payments, which have reached 2.8% GDP. The
budget approved by Congress for 2016 implies that the deficit might increase further in the
absence of new measures. The package of tax reforms envisaged by the government, as
discussed below, together with stricter expenditure control by the Ministry of Finance, if
legislated and implemented, would lead to a deficit reduction of about 2% of GDP during
2016-17.

Tax revenue is close to the Latin American average but substantially lower than in OECD
countries (Figure 6). The overall fiscal system is overly reliant on social security
contributions, which account for about 34% of total government revenue, against 18% in
Latin American and 27% among OECD countries. The contributions of income taxes and
VAT are lower than in other Latin America countries and, especially, OECD countries

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because of tax evasion, a narrow tax base and low marginal tax rates. The current standard
VAT rate is 13%, considerably below the 19.1% average rate for OECD countries. A large
amount of personal income is not taxed since the tax-free threshold is around twice the
average wage in the private sector – much higher than OECD countries and comparable Latin
America countries such as Mexico and Chile.

To start tackling the fiscal problems, the Government has proposed two bills to increase
revenue by about 2% of GDP. Most of the increase, about 1.3% of GDP, is to come from the
introduction of a full-fledged VAT system; around 0.6% of GDP from income tax reforms,
and the rest from a revision of taxes on sales of property. According to the government, these
bills should increase overall revenue by 1.56% of GDP during the first year after their
approval, by another 0.45% in the second year, and another 0.08% in the third. The reform is
consistent with OECD evidence showing that broadening tax bases and relying more on VAT
reduce the detrimental effects of higher taxes on economic growth and employment (OECD,
2008; OECD, 2010b).

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The proposed VAT bill will broaden the base to include most services, which are currently
exempt, and increase the rate from 13% to 14% in the first year and to 15% in the second
year. While broadening the tax base, the VAT bill still contains numerous exemptions and
reduced rates. VAT exemptions benefit mostly well-off taxpayers (Barreix, 2014) and
complicate tax administration; for these reasons they should be repealed, especially as the bill
also introduces an innovative VAT refund system to compensate the poorest 40%
households. The VAT refund system is a positive step as, if implemented correctly, will
drastically reduce the regressivity of the VAT reform. The proposed VAT reform will not
have a significant impact on inequality, but it is expected to lower the poverty rate by about 3
percentage points.

The government also proposes to introduce two new top brackets in the personal income tax,
with rates of 20% and 25%, at 5 and 10 times the average income, which would slightly raise
the progressivity of the personal income tax (Figure 7). However, average tax rates would
remain very low and the tax-free threshold would still be high. As a reference, while on
average for OECD countries a worker earning the average wage pays 25.5% of her gross
wages in personal income tax and social security contributions, in Costa Rica that figure
would not be reached even at 10 times the average wage. Besides, in Costa Rica the income-
tax-free threshold is almost twice the average wage – against about 0.3 times the average
wage in OECD countries on average. As a result, only around 14% of Costa Rican wage
earners pay any income tax. Income taxes could generate more revenue by lowering the tax-
free threshold and bringing more households in the tax net.

The government should reassess the usefulness of the numerous tax expenditures, which
reduced government revenue by almost 6% of GDP in 2013 (Ministerio de Hacienda, 2014b).
Currently there are more than 1 200 tax expenditures. Only about one-fifth of exemptions
have a time limit and nearly half are badly defined (Estado de la Nación, 2014). The

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government has proposed to eliminate some of these tax exemptions by taxing capital gains
and profit remittances to foreign shareholders at a flat rate of 15%. However, some entities
would remain exempt from income taxes, such as large cooperatives in the agricultural
sector. Comprehensive evaluation of tax exemptions and expenditures, such as what the
export promotion agency recently conducted (PROCOMER, 2015), should be used more
widely to inform decisions.

The corporate income tax rate will be kept at 30% but the tax schedule for SMEs will switch
from two brackets (10 and 20%) to four (from 10 to 25%).Although the change in how the
tax brackets’ thresholds are determined (from gross income to profits) is welcome, overall the
reform will increase the complexity of the tax system by raising the number of tax rates.
Multiple tax rates result in unequal treatment of similar taxpayers and curtail SMEs’ growth
(OECD, 2015j). Evidence from OECD countries indicate that preferential tax treatments for
SMEs are not likely to be justified; eliminating or reducing them could free resources for cuts
in the statutory corporate tax rates (OECD, 2010b). Moving to two corporate tax rates – one
for larger companies one for SMEs – or, even better, to a single one might be a simpler and
more efficient way to raise revenue.

Another important aspect of the reform enhances the administrative and punitive capacities of
the tax administration, which is warranted given that tax evasion in Costa Rica amounts to
around 8% of GDP (Ministerio de Hacienda, 2013). In the medium-term, Costa Rica would
greatly benefit from a rebalancing of the tax mix. Shifting taxation away from social security
contributions towards less distortive or more progressive taxes – such as VAT, or income and
property taxes – would have a positive effect on stimulating growth and formal employment
in addition to reducing inequality and poverty.

Public employment reform is urgent to control the Public-Sector wage bill

Costa Rica’s public-sector wage bill as a share of GDP is higher than in most OECD
countries, even though its public employment share is among the lowest, and public-sector
wages account for a large share of total government expenditure (Figure 8). Also, the public-
private sector wage difference is large especially for low-skilled employees and for
employees of public-sector agencies outside the central government (Figure 9).

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Reforming public-sector employment to improve the quality of public services as well as to
control the growth in the public-sector wage bill is urgent. Reforms of the public employment
regime should center on simplifying and making more transparent the different remuneration
schemes across the whole public sector. Last September, the Government created a Joint
Commission formed by legislators, representatives from the executive, trade unions and
private sector to address three issues: quality of public services, remuneration systems of the
public sector and sustainability of pension regimes. The Government has also taken action to
re-negotiate abusive clauses on collective labor agreements, particularly in state-owned
enterprises. More efficient and fair management of compensation should also tie salary
increases to performance evaluation and not just to seniority. In this matter, the Government
presented to the Legislative Assembly a bill that limits the pay increases for the whole public
sector and also establishes a new performance management system.

Controlling the public-sector wage bill is made difficult by a highly fragmented public
employment regime. Remuneration in the public sector comprises a base salary and several
additional remunerations; the Civil Service Regime alone has close to 190 additional types of
remuneration (MIDEPLAN, 2012) and other public employment regimes, such as those of
agencies outside the central government, state-owned enterprises, the Supreme Court of
Justice and the Legislative Assembly, have also several additional types of remuneration.

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Additional remunerations are so high they often are above base salaries. The heterogeneity of
pay schemes generates distortions and inequalities as positions with similar requirements
have dissimilar pay, which also hampers workers’ mobility (CGR, 2009; Academia de
Centroamérica, 2014).

SOME MORE ISSUE FACING COSTA RICA

Overhauling the Costa Rican fiscal policy framework

Costa Rica’s public sector is highly fragmented, resulting in the Legislative Assembly
approving less than half of total public-sector expenditure (Figure 10). Spending not subject
to parliamentary approval includes agencies with some degree of autonomy, namely
“deconcentrated” and decentralized institutions and public corporations. The yearly budgets
of these institutions, as those of the public corporations, do not have to be approved by the
Legislative Assembly but by the Comptroller General, and approval is from a legal rather
than a policy standpoint. In addition, there is no effective mechanism to ensure that these

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agencies’ objectives are aligned with those of the central government. Strengthening the
control of the Ministry of Finance over public-sector expenditure is therefore necessary to
durably improve public-finance management and rationalize transfers to public-sector
agencies outside the central government.

Reducing mandated spending and revenue earmarking would make the budgetary process
more flexible in responding to unexpected shocks. In 2014, around 70% of central
government expenditure was mandated by constitutional and other legal provisions (Table 3);
This, plus, debt servicing, leave only about 17% of the Central Government’s budget for
discretionary spending. Such extensive use of revenue earmarking and mandated spending
contrasts with the principles OECD Recommendation on Budgetary Governance and should
be reduced (OECD, 2015b). Reducing budget rigidities could be complemented with the
introduction of performance budgeting that would enable to allocate and revise spending
based on output targets. Performance budgeting could strengthen incentives to raise public
spending efficiency but these should be balanced by the risk of making the yearly budget
overly complex and the difficulties in defining unambiguous targets (OECD, 2015l).

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Public debt is rising

Increased deficits have resulted in rising public debt. The proposed fiscal reform will be just
enough to stabilise the debt-to-GDP ratio, but not if growth turned out to be below the
historical average (Figure 11). Hence, additional fiscal measures will be necessary to reduce
the debt ratio or stabilise it at current levels if growth turned out less than assumed (Figure
11). Moreover, as a small open economy subject to shocks, Costa Rica should build up
precautionary fiscal buffers, which calls for prudent debt levels.

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Enhancing public debt management institutions would also improve debt sustainability. In
Costa Rica, debt management is split between two agencies of the Ministry of Finance
(Mendis, forthcoming). A single agency tasked with both cash and debt management would

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improve the understanding of debt vulnerabilities, lower costs, help to develop deeper
markets for domestic debt and increase resilience to external shocks (Mendis, forthcoming).

Monetary policy is moving towards inflation targeting but financial dollarization

remains high

Over the past decade, the monetary policy framework has gradually been moving towards
inflation targeting, which has strengthened the overall macroeconomic policy framework.
This move should be accompanied by strengthening the effectiveness of monetary policy to
achieve price stability through appropriate institutional reforms. More specifically, delinking
the designation of the President of the Executive Board from the political cycle, introducing
clear motives and rules for his/her dismissal and depoliticizing the composition of the
Executive Board would enhance the operational independence of the BCRR. Empirical
evidence indicates that operational and procedural independence of central banks is
associated with lower and more stable inflation.

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Together with the ongoing shift to inflation targeting, Costa Rica has moved from a crawling
peg regime to an exchange-rate crawling band and then to a managed float since early 2015.
Evidence suggests that this has reduced the pass-through of exchange rate movements to core
inflation (Figure 12).

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The BCCR continues to intervene in the exchange market, so as to avoid large fluctuations in
the exchange rate, which could be destabilizing in a highly-dollarized banking system.
However, the BCCR does not seek to influence the level of the exchange rate, leaving its
determination to market fundamentals. Evidence shows that exchange-rate interventions have
reduced exchange-rate volatility (Figure 13). Nonetheless, this transitional regime involving
foreign exchange interventions should not be allowed to last longer than necessary, since
permitting the currency to float more freely will induce agents to incorporate exchange rate
risk in their decisions, thus lowering dollarization. Costa Rica would be well served by a
fully-fledged inflation targeting regime, accompanied by a free float, as successfully
experienced by other Latin American countries such as Mexico, Colombia, and Chile.

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Costa Rica’s financial system is highly dollarized, especially bank loans, which constitutes a
significant vulnerability (Figure 14). Financial dollarization increases the likelihood of crises
after a depreciation of the local currency. It is also associated with slower and more volatile
output growth and less stable demand for money and usually entails low financial depth
(Levy-Yeyati, 2006). So far, the shift to a managed float, which should in principle raise the
perception of currency risk, has not reduced the level of dollarization (Figure 14).
Nonetheless, this should eventually happen as families and businesses start pricing exchange
rate risks. Experience from other Latin American countries indicates that the adoption of a
floating exchange rate contributes to a decline in foreign currency-denominated liabilities
with a lag of three years from the change in exchange rate regime (Kamil, 2006).

To speed up de-dollarization, in early 2015 the Central Bank imposed a 15% reserve
requirement for all foreign funding in the financial system. This requirement should be
maintained and if necessary increased. Also, the BCCR and SUGEF, the banking regulator,
need to incentivize the use of derivatives to manage exchange rate risks. The basic regulatory
framework of derivative instruments is already in place. Authorities should press for the
issuance of more standardized derivative contracts to be traded in organized markets, instead
of over the counter, and with lower minimum requirements, which presently are too high for
SMEs.

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Apart from dollarization, the banking sector appears solid by standard metrics. Banks’
capital-to-asset ratios have remained above the regulatory benchmark of 10% and capital
mainly comprises Tier 1 instruments (Basel I) (Figure 15). The liquidity profile is strong,
despite a rising loan-to-deposit ratio that leads to the use of foreign funding instead of
deposits, and Basel III standards are being progressively adopted. Actions are needed to
reinforce the macro-prudential framework and bring it closer to current practices in OECD
countries, where recent initiatives have concentrated on credit and capital measures (OECD,
2013a). In Costa Rica, accelerating the adoption of Basel III principles, publishing the results
of the stress tests carried out by the SUGEF would increase transparency and foster market
discipline; establishing a bank resolution regime and using tools such as capital surcharges
for systemic institutions, loan-to-value ratio and capital buffers would make the system more
robust. Moreover, regarding the attributions and resources of SUGEF, bank supervisors
should be granted additional legal protection and regulation should be amended to allow
SUGEF to conduct supervision of banking groups on a consolidated basis and its funding
scheme, heavily dependent on the Central Bank, should be aligned with international
standards and rely on charges on regulated institutions.

SUMMARY OF RECOMMENDATIONS

The recommendation along with their respective problem identifications can be summed up
in a tabular form as follows.

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35 | P a g e
Costa Rica’s Economic Analysis (2016-15)
GDP 52.7 billion USD

Balance of Trade -5.4 billion USD

Export 9.9 billion USD

Import 15.3billion USD

Government Expenditure 9.96 billion USD

Costa Rica’s GDP grew by 0.19% in 2016, a fall from 6.26% in 2015. The government
spending increased from 9.59 billion USD in 2015 to 9.96 billion USD in 2016. The year was
once again marked by negative trade balance with imports amounting to 15.3 billion USD and
exports constituting 9.9 billion.
Public debt constitutes about 45% of the GDP. The government cut down on capital
expenditure in 2016.The government spending increased by only 0.6 % in 2016.The major
concern however was the fact that almost one third was to be used for debt payments. In order
to meet the increasing expenses government has expressed its desire to come up with higher
VAT and higher income tax rates. In 2017, government increased its proposed expenditure by
12% to concentrate more on capital expenditure. Lack of maintenance and innovation in the
infrastructure poses a major challenge before the government. The government has decided to
collaborate with the Chinese government to improve the condition of ports and thereby reduce
its cost to an extent.
The fast-rising public-sector wage bill is the most important cause of the increase in
government spending. The measures to improve the tax structure and stricter expenditure
control is the need of the hour.

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The above figure shows the trade balance of Costa Rica for 2016 and 2017. The figure depicts
that the balance of trade has improved in 2017 from that of 2016.

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Figure 2 Costa Rica’s Export (2016 and 2017)

Figure 3:Costa Rica’s Import (2016 and 2017)

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Costa Rica’s Economic Analysis (2015-14)

GDP 52.6 Billion USD

Balance of Trade -5.9 Billion USD

Exports 9.2 Billion USD

Imports 15.1 Billion USD

Government Expenditure on education 3.77 Billion USD

The macroeconomic situation in 2015 was marked by political stability and a

business- friendly framework. In terms of ease of doing business, regulatory quality and
control of corruption the country fared better than the neighboring Latin American Countries.
The exchange rate policy was changed to floating rate system in February 2015. This change
did have a minor impact on the local currency movement as the colon had been a de facto
afloat since mid-2014. The government struggled to control the fiscal deficit which widened
to 6% of the GDP. The government tabled proposals of increasing the VAT rate and the
individual income tax rate but they were not passed by the Congress. Consequently, public
debt rose rapidly to 44% of the GDP in 2015, almost twice its level in 2009.

The year also marked Costa Rica’s high dependence on

oil imports (13% of total imports) and agricultural exports (18% of total exports) making the
small economy vulnerable to hazards energy and commodities price. The economy heavily
relied on the performance of the US economy with 61 % of the FDI coming in from the US.
Costa Rica’s easy access to capital markets kept financial and external risks under control.

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Costa Rica’s Economic Analysis (2014-13)

GDP 49.5 Billion USD

Balance of Trade -6.4 Billion USD

Exports 9.2 Billion USD

Imports 15.6 Billion USD

The growth rate in the year 2014 stood at around 3.5%, below its trend rate of 4.25%. The
unemployment rate which had elevated since the Global Crisis increased even further. The
central bank lowered the target inflation rate from 4-6 % to 3-5%. Owing to sticky inflation
rate expectation above the target range saw inflation reach 5.7% in October 2014.The real
effective exchange rate declined by 4% with nominal depreciation outpacing a growing
inflation differential. In order to reduce the public account deficit a new anti-tax evasion bill
was brought in. Intel’s decision to shut its microprocessor manufacturing plant had an adverse
impact on exports. Intel contributed a lot to Costa Rica’s exports. Microprocessors constituted
21% of exports in 2013 when coffee and banana together constituted 10% of the experts. The
first half of 2014 saw the exports grow by only 1.7% from 5.825 to 5.922 billion US dollars.
In wake of normalisation of US monetary policy, the currency lost 10% of its value between
January-March 2014.The persistence of a large fiscal deficit and rise in public debt ratio
continued to be a major concern for the economy. The productivity growth in Costa Rica
remained high with labour generating positive contributions during downturn. The
unemployment rate remained high at 7.7%, third among the Central American countries behind
only Dominican Republic (14.7%) and Nicaragua (8%). The employment to GDP elasticity of
Costa Rica was computed to be 0.46 which suggested that the unemployment might increase
in the coming years.

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 .

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Costa Rica’s Economic Analysis (2013-12)
GDP 49.2 Billion USD

Balance of Trade -6.4 Billion USD

Exports 8.6 Billion USD

Imports 15.1 Billion USD

Growth actively rose by 3.5% in the year 2013. The growth rate decreased from 5%in
2012 on account of weaker consumer spending. The current account was mostly financed by
FDI inflows. The current account deficit hovered close to 5% of GDP. Costa Rica gained
export market share during the same period in contrast to other emerging countries. Financial
eased in early 2013 with Eurobound placements. The domestic interest rates had increased
substantially in 2012 driven by large government borrowing and buoyant private sector credit
demand. The government reduced the interest rates in the first half of 2013 but the interest
rates increased in the second half of the year as financial situations tightened. The total FDI
stock in Costa Rica amounted to 40% of the GDP of which investments from US accounted
for 64%, followed by Britain and Spain with 6% each.

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Costa Rica’s Economic Analysis (2012-11)

GDP 45.3 Billion USD

Balance of Trade -6.2 Billion USD

Export 8.7 Billion USD

Import 14.9 Billion USD

The overall public-sector deficit stood unchanged at about 4.5 %. Efforts were made at
containing expenditure growth and better tax administration with newer proposals. The
consolidated public-sector debt rose to 38% of the GDP .Net international reserves rose to 6.9
billion US dollars which reflected the large purchase of US bonds which the central bank had
done. Financial sector remained strong with liquidity and capitalization at adequate levels.
Financial conditions eased towards the end of the year and the credit to private sector increased
by about 13% in nominal terms. The balance of risks tilted to the downside along with domestic
policy challenges. The growth rate in US remained weaker than expected and thus a negative
sentiment for the economy of Costa Rica. Also, a global financial shock, or a rise in world oil
prices stood as the major risks to the economy. Oil constituted the biggest portion of import by

value and export products consisted mainly of medical equipment, banana, coffee and
electronic devices.

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CONCLUSION

Over the last quarter century political leaders and policymakers in virtually every country in
the world have been confronted with the same question: In the wake of widespread political,
technological, and institutional change around the world, what changes must be introduced
into the economic and financial architecture of a country’s economy that is firmly anchored
in the world economy of the 21st century that will lead to improvements in the nation’s
material well-being? From China to Brazil, from Russia to South Africa, from Japan to
Australia, from India to North Africa, and, most recently from the United States to Western
Europe, all have struggled, or are struggling, with this “existential” problem.

The objective of this report has been to describe the predicament of Costa Rica, a small
country, that is located in a relatively politically and economically dysfunctional region of the
global economy. Costa Rica is a country without endowments of fuel and non-fuel mineral
resources and without an economically viable manufacturing sector that produces durable
consumer goods. So, how does Costa Rica arrange its “assets” -- its geography, its climate,
and its human capital -- to improve the living standard of its population within the framework
of the fiercely competitive global economy?

The first step is to identify the country’s strengths and weaknesses, and then, through the
political process and in collaboration with its business leaders and policymakers, to develop
and implement the necessary policies to reduce or eliminate these weaknesses on the one
hand, and, on the other hand, to nurture and provide the necessary incentives to exploit the
country’s strengths.

This report has emphasized the need for Costa Rica to confront its chronic fiscal deficits
aggressively and its global challenges that include attracting much-needed foreign direct
investment that can be combined with Costa Rica’s relatively educated labor force,
combating the global scourge of drug trafficking (and its inevitable co-product, violent
crime), and growing its specialized “niche” sectors (biodiversity and ecotourism) to
complement its exports of bananas, coffee, and other traditional exports.

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References
1. World Bank Report, Country Overview-Costa Rica
http://www.worldbank.org/en/country/costarica/overview

2. International Monetary Fund article on Economy of Costa Rica

https://www.imf.org/en/News/Articles/2015/09/28/04/53/pn1325

3. IMF Costa Rica: 2014 Article IV Consultation--Staff Report; Press Release; Staff
Statement
https://www.imf.org/en/Publications/CR/Issues/2016/12/31/Costa-Rica-Staff-Report-for-
the-2014-Article-IV-Consultation-42682

4. Trading economics
https://tradingeconomics.com/costa-rica/inflation-cpi
https://tradingeconomics.com/costa-rica/indicators
https://tradingeconomics.com/costa-rica/government-spending

5. OCED report on Costa Rica

https://www.oecd.org/gov/lac-costa-rica.pdf

6. World Bank Data report

https://data.worldbank.org/indicator/SE.XPD.TOTL.GD.ZS

7. Euler Hermes research report on Costa Rica

http://www.eulerhermes.com/economic-research/country-reports/Pages/Costa-Rica.aspx

8. BMI research report on Costa Rica

http://www.latinamericamonitor.com/analysis/central-america/costa-rica/monetary-
policy
http://www.latinamericamonitor.com/economic-analysis-loose-monetary-policy-will-
persist-through-h116-jan-2016
http://www.latinamericamonitor.com/economic-analysis-deflationary-conditions-
presage-further-loose-monetary-policy-june-2016

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